The methods of evaluating the opportunity of an investment project are the NPV method and the IRR method. If the NPV of the project is greater than zero or the IRR is greater than some minimum predetermined rate, the project is profitable, thus it should be undertaken.

However, a strong piece of information to consider is the firms cash flows over time. This way we will have a more detailed image of the project and see not only if the project is profitable, but also when it becomes profitable, how much of the initial cost is recovered every year, etc.

The first step in this analysis is to calculate the cash flows and discounted cash flows (with the previous years’ cash flows (up to and including the current year) and will show how much money is still invested or tied in the project at this time. appropriate signs) generated by the project. Based on them we can calculate the following:

1) The percentage of the discounted cash flows in the initial investment.

Usually the investment or the initial cost occurs in the first year(s) of the project and is registered as a negative cash flow. If the investment is spread over several years, the initial investment is considered to be the sum of all these yearly expenditures, or more correctly the sum of all discounted expenditures (which is the PV in the first year of all investments to be made for the project).

The percentage of each cash flow in the initial investment tells us how much we invest or how much we recover from our total investment every year during the economic life of the project.

If the initial investment is considered in absolute value, thus a positive number, and each cash flow is considered with the appropriate sign, then the percentage of discounted cash flows will be negative for the years when the project requires investments and positive for the years when the project generates revenues.

2) The accumulated percentage of the discounted cash flows in the initial investment.

For each year, it is simply the sum of the percentages previously calculated for all the years before and including the year considered. It roughly shows how deep we are into debt. An accumulated percentage of -100% will be obtained for the year when the investment is completed. This is when the debt is the ‘deepest’. After this year we will start recovering some part of the investment every year and the accumulated percentage will show how much there is still to be recovered from the investment. The accumulated percentage for the last year will equal the percentage of the PV ofthe project (i.e. the sum of all discounted cash flows) in the initial expenditures or investment.

3) Cash balances

They are the sum of all cash flows already realized at any given point of time (considered with the appropriate signs). For each year the cash balance will equal the sum of all Cash balances are initially negative for most projects, as they start with expenditures (investments). It is important to note the maximum (negative) cash balance in absolute value and when it occurs. This number will show the maximum investment that, at some point in time, is tied in the project. Even if the project is overall profitable (check this through the NPV and IRR methods), if one cannot procure this maximum (negative) cash balance at the particular time when it occurs, one cannot undertake the project.

As the project starts generating revenues, cash flows become positive, thus the negative cash balances decrease in magnitude, but are still negative for a while (as long as revenues generated by the project do not exceed the investment). The decrease in the absolute value of cash balances simply shows that the investor starts to recover part of the investment made.

A second thing important to note is when we obtain the first positive cash balance. This moment is called payback period and represents the period of time needed to recover all the initial investment and obtain the first dollar of profit.

The sum of all cash balances at the end of the project will equal the sum of all undiscounted cash flows. A problem raised by cash balances is that they do not take into account the interest that must be paid for any amount borrowed from the bank or the interest earned on any amount saved in the bank. In reality, the negative cash balances carried forward from one year to another in the first years of the project are equivalent to a debt, on which interest should be paid. Once cash balances tum positive, they are equivalent to some money saved in the bank and interest is earned for all subsequent years.

Thus, a better measure of the amount of money tied in the project is given by the interest based cash balances.

4) The interest based cash balance (IBCB)

The IBCB for the current period is obtained by adding the current (undiscounted) cash flow to the IBCB carried from the previous period and the interest that applies to it (the formula doesn’t work with subscripts). Like cash balances, IBCBs for the project are negative for the first years (due to investments or outflows) and become positive as the project generates enough revenues to recover the costs. For most of the projects the maximum negative IBCB, which shows the maximum amount invested in a project at any given point in time (when interest is considered) is greater than the maximum negative cash balance. This is simply because for any amount invested, like for any debt, interest should be paid.

The interest based payback period (or discounted payback period) is the moment when the project’s inflows exceed the project outflows, interest being considered, or the moment when we obtain the first positive IBCB. It is usually larger than the payback period. The reason for this is that we need time to recover not only the initial investments or expenditures, but also the interest that applies to them. The last IBCB obtained for the project will equal the future value of the project in the final year (the accumulated sum of all cash flows compounded with the appropriate interest rate).

5) The profitability index- PI (the cost-benefit ratio)

This ratio calculates the PV of all inflows (benefits) to the PV of all outflows (costs). A project is profitable when its NPV is positive, thus the PV of benefits is higher than the PV of costs. It must be then that the project should be undertaken when the profitability index is greater than 1, and it is not profitable when the index is less than 1.

This post is part of a series of articles on cash flow analysis. Visit our cash flow analysis page to find a summary of each method.